Make $377,000 trading Apple in one dayAugust 30, 2013: 8:31 AM ET
A Berkeley professor finds out just how much a certain type of high frequency trading costs the average investor.
By Rob Curran
FORTUNE -- Two recent studies of latency arbitrage suggest the stock-market structure needs a remodel if it's ever going to stop billions of dollars going from unwitting investors into the pockets of high-speed trading firms.
"Latency" refers to the time it takes for a stock quote to get from an exchange's server to a trader's screen. This varies from exchange to exchange and from trading computer to computer. Latency arbitrageurs take advantage of these inconsistencies.
It's well known that some high-frequency computer geeks at firms like Getco LLC take advantage of latency, just as it's well known that some Blackjack-playing computer geeks count cards in Las Vegas casinos. But it's never been clear how much this type of trading costs the little guy on Wall Street.
Terrence Hendershott, a professor at the Haas business school at the University of California at Berkeley, wanted to find out. He was recently given access to high-speed trading technology by tech firm Redline Trading Solutions. His test exposes the power of latency arbitrage the way Ben Mezrich's Bringing Down the House exposed the power of card counting.
According to his study, in one day (May 9), playing one stock (Apple (AAPL)), Hendershott walked away with almost $377,000 in theoretical profits by picking off quotes on various exchanges that were fractions of a second out of date. Extrapolate that number to reflect the thousands of stocks trading electronically in the U.S., and it's clear that high-frequency traders are making billions of dollars a year on a simple quirk in the electronic stock market.
One way or another, that money is coming out of your retirement account. Think of it like the old movie The Sting. High-speed traders already know who has won the horse race when your mutual fund manager lays his bet. You're guaranteed to come out a loser. You're losing in small increments, but every mickle makes a muckle -- especially in a tough market.
"It's clear to us these guys are just raping, pillaging, and plundering the market," as Joe Saluzzi, co-founder of agency brokerage Themis Trading put it.
Here's how Hendershott's latency-arbitrage strategy worked: Redline allowed him to use its "direct market access" -- cables that run directly from exchange servers to its own. Redline's server was co-located with that of BATS Exchange so that the "latency" on information and orders coming from BATS was cut down to barely one thousandth of a second. As a result, some of the quotes on public feeds such as the crucial "national best bid and offer" feed were a few milliseconds behind those Hendershott could see on his direct link with the exchanges. With a half-decent trading algorithm, Hendershott would have had ample time to buy Apple at a stale price with a guarantee that he could sell at a profit. Every couple of seconds. All day. Risk on the trades: zero.
Firms with technology like Redline's "can simply out-compute the [feeds] to derive ... a projection of the future [quotes] that will be seen by the public," says Michael Wellman, a professor at the University of Michigan, and his co-autho,r university fellow Elaine Wah, in their own study of latency arbitrage published in June.
No wonder Saluzzi and his colleagues at Themis were exasperated by the reason Nasdaq (NDAQ) chief executive Bob Greifeld gave for the exchange's three-hour halt on Aug. 22: "We knew professional traders had access to individual data feeds, but the traditional long investor, retail investor now didn't have the same information," Greifeld said on CNBC.
To Saluzzi, Greifeld had just described the unfair advantage enjoyed by high-speed traders every day. That prompted the question on Themis's blog: If Nasdaq halted the market on Aug. 22, "shouldn't they halt the market all of the time?"
Like others before them, Wellman and Wah's study found latency arbitrage was eating investor profits. Unlike others, Wellman and Wah proposed an elegant alternative to the market structure.
Previously, regulators and high-speed traders alike had argued that the "latency" problem could never completely go away, because information can never be disseminated by all exchanges at precisely the same instant to all investors.
The authors suggest that the perpetual motion tape be replaced by a stop-motion tape. Instead of a continuous, free-for-all market, the session would take the form of a series of lightning-fast-auctions at intervals of a few milliseconds. This would give exchanges a reasonable amount of time to disseminate information (most only take a few thousandths of a second to catch up on the "direct access" feeds). It would also give traders a reasonable amount of time to place bids and offers on a given stock. The average investor would not see the difference because prices on active stocks would still be changing many times per second.
Such a system would be impossible to game. It would end the high-speed arms race. Firms like Spread Networks would have no reason to lay cables from Chicago to New York just to make sure high-frequency traders remain a few millionths of a second ahead of the manager of your retirement account's mutual fund.
Update: An earlier version of this article incorrectly referred to Strike Technologies as an example of a firm laying cables for high frequency trading. It was Spread Networks.